How discount rates are determined by a policymaking body Literature Review

REVIEW OF LITERATURE

Geoffrey M. B. Tootell (2000) tackled how discount rates are determined by a policymaking body. In the United States, private citizens play little direct role in policymaking. The directors of the boards of the regional Federal Reserve banks are an apparent exception to this rule. These directors recommend changes in the discount rate, although the Board of Governors decides whether to act on the recommendations. These directors would have greater influence if they affected the FOMC votes of their district bank presidents. Tootell’s paper showed that the FOMC votes of the regional bank presidents are strongly correlated with the discount rate recommendation of their bank’s board. Several alternative explanations for the correlation are then examined.

A district’s discount rate recommendation is clearly a powerful signal of that Reserve bank president’s FOMC vote. Although the discount rate recommendation does depend on many of the same economic variables as the FOMC vote, it adds marginal predictive power for the FOMC vote beyond these macrovariables. Yet the discount rate recommendation is not simply the district president telegraphing his or her punch, and the FOMC vote is not the president simply following orders from his or her local board since the determinants of the two decisions differ significantly. The correlation seems to derive from idiosyncratic information not related to the macroforecasts in the Green Book but shared at the regional level. Different information appears to be emphasized in the different regions, and some evidence suggests that the FOMC as a whole finds this information useful.

The implications for monetary policy are important. If monetary policy were being disproportionately influenced by concerns about the regional economic performance or by narrow private interests, the federal structure could be suboptimal. There is little evidence that local conditions in these regions overly affect presidents’ votes at the FOMC meetings. However, the meeting of the local boards and district presidents does seem to affect the presidents’ FOMC votes, and this could be beneficial if it results in the presentation of different information, different points of view, or different forecasts at the FOMC meeting. In fact, there is evidence that the discount rate recommendations related to idiosyncratic information at the district level often affect the votes of the other FOMC members; this highlights one important benefit of the Federal Reserve System–its inclusion of different views for a full debate. In this way, the presentation of different perspectives at the FOMC justifies its structure as a committee including representation from different regions.

Amit Sen , Gregory M. Gelles and Walter D. Johnson (2001) studied the net discount rate. The net discount rate, measured as the average difference between the nominal wage growth and the nominal interest rate over the available historical period, is often used by forensic economists to determine the present value of future earnings losses. The correct value to use for the net discount rate has, in recent years, been a topic of controversy and extensive discussion among practitioners. A number of studies in the literature have A number of studies in the literature have advocated the use of net discount rates close to zero. The use of this “total offset” method is based on a calculation of the average net discount rate over time using the return on 91-day treasuries as the nominal interest rate. Critics of the total offset method argue that it yields. The three authors did an analysis of the net discount rate approximated by the difference in the interest rate on the 91-day Treasury Securities and the growth in average weekly earning of all production workers in the United States using quarterly data for the period 1964:01-1999:03. Perron’s (1997) methodology was used to test for non-stationarity in the net discount rate series. These tests are designed to have power against the stationary alternative that allows for a single shift in the mean. Unlike previous studies, this testing procedure does not require pre-specification of the break-date. Rather, the break-date is determined endogenously. In the eventuality that the test statistics are significant, the break-date may be estimated as the time point in the sample that maximizes the evidence against the unit root null hypothesis. Our results indicate that the net discount rate is best characterized as a stationary process with a single shift in the mean and that this shift occurred during 1978:03.

In another study, the author highlighted the complications in comparing the various reports from British firms which use different discount rates for calculating net present values. Sofregaz originally used 7.5 per cent, though in its later calculations it uses 7 per cent, BG/KeySpan use 8 per cent, while the Shannon-McManus report uses 7 per cent. The test rate recommended by the Department of Finance for non-commercial public sector capital projects is 5 per cent, though in the case of commercial projects which may involve higher than average risk, a somewhat higher rate may be appropriate. Evaluations carried out on the first interconnector have used 7 per cent.

That said, the discount rate is meant to represent the cost of capital or the required rate of return for a project. In the low inflation and interest rate environment that exists at the moment, both the cost of capital and the required rate of return on investments in the general economy have been falling. This would suggest that the discount rate used to evaluate this project should also be lower than that used in the past. The real rate of return on Irish State index-linked bonds has recently been around 2.7%.

UK regulators have recently been indicating that permitted real rates of return for the various industries subject to tariff controls may be in the range 5 to 6 per cent. There has as yet been no determination in Ireland of the rate which will be permitted, although it is clear from the Electricity Regulation Bill currently before the Oireachtas that there will certainly be a ceiling. At this stage, our judgement is that it could well be lower than the 7 and 8 per cent real rates used in the various studies listed. Where the timing of expenditure differs between investment options, the discount rate chosen can have an impact on the determination of the least cost option.

Therefore it is important to investigate the sensitivity of the various options to changes in the discount rates used. We have done this, for the three reports in question, for discount rates of 5, 6, 7, and 8 per cent.

We consider here the revised data produced by Sofregaz, as opposed to that produced for the Gas 2025 report.

Table 9.1: Sensitivity Analysis to Discount Rates, Sofregaz/BGE Figures

UK1

UK1 S-N

UK2

1998 US$

Gas World B:

Capex

827

868

933

Capex + Opex discounted at:

754

786

853

700

730

791

652

679

736

609

634

686

Conventional Wisdom:

Capex

658

733

Capex + Opex discounted at:

551

608

649

507

560

597

468

517

550

433

479

509

Note: The rate used by Sofregaz/BGE is 7 per cent.

As can be seen, UK1 is the least cost option, followed by UK1 S-N, and UK2. Discounting, and the choice of discount rate within the range considered here, make no difference to this ordering, but affect the size of the gap.

This is an interesting case, because for the central demand case and a discount rate of 8 per cent, while the Scotland-Dublin route is cheaper in Capex terms, it is more expensive in NPV terms. It follows, that at some discount rate, the Scotland-Dublin route is cheaper. This rate cannot be determined with accuracy, because the report only gives 5-yearly capex and Opex figures, and these only for the central demand case. BGE would not provide us with yearly figures, citing confidentiality reasons. Without yearly figures it is impossible to carry out a proper sensitivity analysis. However, we did carry out an exercise based on the 5-yearly costings in the report, for the central demand scenario.

Subjecting this imputed expenditure schedule to a range of discount rates indicates that the BG/KeySpan and Scotland-Ireland options have an equal NPV at a discount rate just below 6 per cent. Any rate lower than this will favour the latter route. A different expenditure schedule, for example where expenditure happened in the middle of each five-year period, or was spread evenly throughout each period, would further favour the Scotland-Ireland route.

Table 9.2: Sensitivity Analysis to Discount Rates, BG/KeySpan Report

BG/KeySpan Option

Sc-Dublin Option

Difference

US$

Central Demand Case

586

439

147

Capex

Capex + Opex discounted at:

389

380

350

355

- 5

317

333

- 17

290

317

- 26

High Demand Case

Capex

754

591

163

Capex + Opex discounted at:

Insufficient info.

457

393

Low Demand Case

Capex

472

419

Capex + Opex discounted at:

Insufficient info.

254

294

- 40

Notes:

1. The BG/KeySpan report uses a discount rate of 8 per cent.

2. The BG/KeySpan report is expressed in stg£; the exchange rate used is US.65/stg£.

This reflects two features in the BG/Keyspan report – the differences in NPVs are modest, so small changes in the make-up of the figures can have an impact. The Scotland-Ireland route is cheaper in Capex terms under all demand scenarios, despite being more expensive in NPV terms in all but the high demand case.

The lower the discount rate used, the more closely the NPV figures will reflect the Capex figures. As a result, it is not surprising that as the discount rate was reduced the option with the cheapest Capex was favoured.

In the Shannon-McManus report, BG and Sofregaz revisit their calculations, using an agreed databook of assumptions. Both come up with the same ordering of capex for three infrastructure options, equivalent to UK1, UK1 S-N and UK2 in the Gas 2025 report. When a discount rate of 7 per cent is applied, the NPVs are in the same order. Recalculating the NPVs using discount rates ranging from 5 to 8 per cent does not change the order of the projects.

Table 9.3: Sensitivity Analysis to Discount Rates, Shannon-McManus Report

BG Calculations

Sofregaz Calculations

Option 1

Option 2

Option 3

Option 1a

Option 2

Option 3

1998 US$

Capex

787

625

571

780

681

623

Capex + Opex discounted at:

652

539

491

688

589

531

603

502

458

637

547

492

560

473

428

590

509

459

521

439

402

551

475

427

Note:

1. The discount rate used in the report is 7 per cent.

Within the range considered above, only the BG/KeySpan ordering was sensitive to the discount rate used. Lack of detail in this report prevents a proper analysis. However, for their central demand case, and using the timing assumptions we have made, it appears that a discount rate above 5.7 per cent favours the North-South pipeline option, whereas below that rate twinning the Scotland-Ireland interconnector is favoured. Altering the timing assumptions would tend to favour the Scotland-Ireland interconnector.

In all other cases, the ordering of the NPV calculations were robust with respect to the choice of discount rates.

We would note that the gas pipeline industry and the powergen industry are capital intensive, and both will be regulated under Irish legislation. The determination of the allowable real rates of return for these industries will no doubt be an early priority for the regulatory system, and such a determination would help to clarify the uncertainties deriving from this source.

Finally, there is a potential complication, which we merely note here, in that import interconnectors would fall under regulatory review in both Ireland and the UK.

Daniel Farber and Paul Hemmersbaugh (46: 267-304) tackled the importance of the discount rate. If saving a life is worth spending million today, how much should we spend to save a life in twenty years? The answer, according to the federal Office of Management and Budget (OMB), is 0,000. The OMB uses a ten percent annual “discount rate” to convert future regulatory costs and benefits into their “present value.” Because government regulation of carcinogens cannot be expected to affect the cancer rate for twenty or thirty years. OMB’s choice of discount rates has dramatic implications for regulatory policy. Its choice of discount rates has even greater impact on long-term global environmental issues such as ozone depletion and the greenhouse effect.

The basic principle underlying discounting is simple: A dollar today is worth more than a dollar at some time in the future. This is the same “time value” principle that underlies the concept of interest. Suppose lender L loans borrower B 0 in year one, to be repaid in year two. L will forego current use of the 0 only if B pays her a premium for that forgone use when B repays the loan in year two. That premium is interest. If B and L agree that B will pay 0 in year two for the use of L’s 0 in year one, the simple interest rate is ten percent. If we asked L how much 0 in year two is worth to her today, she would presumably answer “0.” L “discounts” the money she will receive in the future by ten percent. This reflects the time value of money principle: X dollars one year from now is worth less than X dollars today.

The term “present value” describes the current value to the recipient of a benefit that will be conferred in the future. In the above example, the present value to L of 0 in year 2 is 0. The ten percent rate L uses to discount the money she will receive in year two is called the “discount rate.” Note that this analysis also applies to costs to be incurred in the future. Everything else being equal, L would be indifferent between paying a cost (for example, a tax) of 0 in year two or 0 today, because L discounts future costs at a simple rate of ten percent per year.

The arithmetic becomes more complicated when more than one period is involved. As money or monetary costs are conferred further in the future, compound interest decreases their present value geometrically. The formula for determining the present value of a sum to be conferred in some future year is:

where Bt represents the amount that the beneficiary will receive in future year t, r stands for the discount rate, and t represents the number of years from the present when the beneficiary receives the money. By substituting the monetary value of the benefit for Bt, one can use the above formula to determine the present value of any future benefit that can be expressed in monetary terms. Analysts similarly can discount future costs expressed in monetary terms to present value.

The costs and benefits of a given government policy often extend over more than one year. A policy generally distributes those costs and benefits unequally over time, so simple comparison of gross costs and gross benefits would ignore the time value of money. Consequently, cost-benefit analysts generally discount all costs and benefits to present value before comparing them. The difference between the present value of all benefits and the present value of all costs of a project or regulation is often called its “Net Present Value” (NPV). A positive NPV (benefits exceed costs) suggests that the government should adopt a regulation and a negative NPV suggests that it should not.

Thus, to determine the NPV, the policymaker must derive a social discount rate that reflects the time value of the stream of costs and benefits for the entire population affected by the regulation. Determination of the appropriate discount rate presents a tremendous practical problem that federal agencies have not resolved uniformly, despite prodding from OMB.

Though justification of the discount rate and estimates of its numerical value vary substantially, economists generally agree that cost-benefit analysis requires discounting future benefits and costs to present value. Given this consensus regarding the need for discounting, an understanding of the impact of the choice of discount rate on the results of cost-benefit analysis becomes important. Discounting can dramatically affect the value of a proposed regulation’s costs or benefits depending on the size of the discount rate and the length of time before society realizes the costs or benefits. Because society often incurs the costs of environmental regulation long before the benefits compound discounting generally has a greater impact in the calculation of the present value of benefits than of costs.

As stated by Devereux and Engel (1998), in all the models the objective of the firm managers is to maximize the expected utility of the representative owner of the firm. The firm picks prices to be charged so as to maximize expected profits. They stick to these announced prices for one period no matter what. These prices are then used to compute the optimal intertemporal consumption choice. In this model, expected welfare will be a function of expected level of consumption and the variance of consumption. Optimal consumption, and ultimately, welfare will be a function of the variance of domestic and foreign monetary shocks and deep parameters such as the discount factor and the relative size of the population in Mexico and the United States. How do these parameters and variances affect ultimately expected welfare? That depends on the different ways the competitive monopolist set prices

Frank Adams and J. Philip Cook (2001) did a paper which focuses on the construction of, and relationship between, discount rates and capitalization rates and then illustrates their proper application and construction in the context of a recent valuation assignment in a property condemnation.

Valuation of assets is inherently subjective. In addition, the particular approach used to determine value, whether it is the income, cost or market data approach, or combinations thereof, is subject to professional judgment. In this particular case, where we have unchallenged and irrefutable evidence on the magnitude of the lease income loss due to the “take,” the income approach must be superior to the market data approach if for no other reason than the arbitrariness inherent in selecting comparable properties.

Competent appraisers can and do have differences of opinion concerning the estimation of cash flows (both amount and length) for income producing property when leases are short term in nature. In addition, differences of opinion do exist concerning appropriate discount rates utilized in valuing cash flows. However, when faced with factual data concerning the magnitude and duration of the lease income loss due to a property condemnation, the only real issue to be debated concerns the discount rate. We have provided evidence here, based on our opinion of the actual character of the income stream, the characteristics of the subject property and the holding period profile of the property owner, that suggests that the “net” discount rate utilized by the APPRAISER was inordinately high.

Daniel Thornton studied the impact of the discount rate on US treasury bills. For some time market analysts have been aware that market interest rates respond to announcements of changes in the Federal Reserve’s discount rate that are made for reasons other than simply to keep the discount rate “in line” with market interest rates. What is far less clear is the reason for the response. Thornton investigated the hypothesis that T-bill rates respond to discount rate changes because the market interprets a nontechnical change in the discount rate as a signal of a change in the Federal Reserve’s target for the federal funds rate. The evidence indicates that the federal funds and three-, six-, and twelve-month T-bill rates respond immediately and simultaneously to announcements of nontechnical discount rate changes. Consequently, there is no way to differentiate this hypothesis from several other hypotheses of why T-bill rates respond to announcements of discount rate changes.

The hypothesis was further investigated by Thornton when he tested whether there was a lag in the response of the T-bill rate to changes in the discount rate during periods when the Fed was using a fuzzy federal funds rate target. The results, that there were no delayed responses, reject Cook and Hahn’s hypothesis that the markets respond to discount rate changes because they signal a change in the Fed’s target for the federal funds rate.

The evidence also rejects Cook and Hahn’s suggestion that their evidence supports the standard view that the Fed controls the structure of interest rates through its influence over the federal funds rate. The degree to which the Fed can influence the structure of interest rates through its ability to influence the federal funds rate cannot be determined by investigating the daily reaction of market interest rates to changes in the discount rate because, at this frequency, the responses are simultaneous.

Charles Engel and, Marco A. Espinosa-Vega suggested in their paper the importance of the discount rate in establishing a country’s currency regime. They said that in order to advise Mexico on the type of exchange rate regime to adopt, one first has to know how firms set prices. They believed however, that if one wants to go this route, one must also provide a more detailed description of how the different layers of frictions in the model (sticky prices, local-currency pricing, and monopolistic competition) interact with each other. Their research also reminds us of the importance of studying the interaction of frictions in the financial markets with the price-setting behavior of the firm.

However, given our limited understanding of price-setting choice of the firm, it may be too early to ask about its interaction with alternative monetary policy rules. They personally would like to interpret this model as a nice contribution to the theory of firm pricing in the presence of alternative exchange rate regimes.

Credit:ivythesis.typepad.com

How discount rates are determined by a policymaking body Literature Review

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